Cost Volume Profit (CVP) Analysis

Defining Costs

• Relevant vs. Irrelevant Costs (from last week).
• Classifying relevant costs based on behavior relative to changes in activity volume:
  • Fixed
  • Variable
  • Semi-Fixed/Semi-Variable

Fixed Costs

• Total Fixed Costs (TFC): Remain constant for a specified period (short/medium term), unaffected by activity changes.
• Affected by time-related changes like inflation (rent, salaries).
• Stepped Fixed Costs: Increase with significant changes in activity over the long term (e.g., expansion requiring new premises).

Variable Costs

• Vary directly with activity (e.g., raw materials).
• Cost increases linearly with volume.

Semi-Variable Costs

• Contain both fixed and variable cost elements.

Activity Bases (Cost Drivers)

• Measures that cause variable costs.
• Examples: machine hours, units produced, direct labor hours, miles driven, etc.
• Identifying activity bases helps in planning and controlling variable costs.

Break-Even Analysis

• The point where total sales equal total costs (no profit or loss).
• CVP analysis is based on calculating the break-even point and analyzing the consequences of changes in various factors.

Cost Volume Profit (CVP) Analysis

• Technique to understand the interrelationship between cost, volume, and profit.
• Focuses on interactions between:
  • Prices of products
  • Volume or level of activity
  • Per-unit variable costs
  • Total fixed costs
  • Mix of products sold
• Idea: In the short run, survival depends on sales revenue covering variable costs.
• Contribution: The amount by which selling price exceeds variable costs.

Break-Even Analysis Methods

1. Contribution Margin Method
2. Equation Method
3. Break-Even Chart

Contribution Margin Method

• Break-even point (units) = $\frac{Fixed \,expenses}{Contribution \,per \,unit}$
• Contribution per unit = Selling Price per unit - Variable Cost per unit

Contribution Margin Ratio

• Break-even point (total sales) = $\frac{Fixed \,expenses}{CM \,ratio}$
• CM Ratio = $\frac{Selling \,price - variable \,cost}{Sales} X 100$

Equation Method

• Profits = Sales - (Variable expenses + Fixed expenses)
• At break-even point, profits = 0.
• Sales = Variable expenses + Fixed expenses + Profits

Target Profit

• Sales volume needed = $\frac{Fixed \,Costs + Target \,profit}{Contribution \,per \,unit}$
• Sales needed = $\frac{Fixed \,Costs + Target \,profit}{CM \,Ratio}$

Uses of CVP Analysis

• Determine sales level to cover fixed costs and achieve specified profit.
• Analyze the impact of changes in selling price, variable cost, or fixed costs on the break-even point.

Margin of Safety

• Amount sales can drop before losses occur.
• Margin of safety = Total sales – Break-even sales
• Margin of safety (%) = $\frac{Margin \,of \,safety}{Sales} X 100$

Revision

• Costs: Fixed, Variable, Semi-Variable
• CVP: Interrelation between selling price, volume, variable cost, product mix.
• CVP assists in decisions about products, pricing, marketing, and facilities.
• CVP is based on covering variable costs in the short run, represented by the contribution margin which helps to cover fixed costs.
• Break-even point: Zero profits, zero losses.

Operating Leverage/Gearing

• Measures profit sensitivity to percentage changes in sales.
• Operating Leverage = $\frac{Contribution \,Margin}{Profit}$
• High Gearing: High fixed costs relative to variable costs; activity changes significantly impact profit.
• Low Gearing: Low fixed costs relative to variable costs; activity changes have less impact on profit.

Marginal Analysis

• Focuses on costs/revenues that vary with the decision.
• Maximizes the value of the company. Used in decisions about:
  • Accepting/rejecting special contracts
  • Efficient use of scarce resources
  • Make-or-buy decisions (outsourcing)

Efficient Use of Scarce Resources

• Maximize contribution per unit of scarce resource.

Outsourcing: Make or Buy

• Financial implications: Which is cheaper?
• Practical implications: Expertise, capacity, quality control, reliability of supply.